The validity of options under securities law

By Shailaja Lall and Shivangi Talwar, Shardul Amarchand Mangaldas & Co
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The Bombay High Court, in Edelweiss Financial Services Ltd v Percept Finserve Pvt Ltd and Ors, held that a put option in a share purchase agreement (SPA) was neither a forward contract, nor a ‘contract in derivative’ within the meaning of the Securities Contracts (Regulation) Act, 1956 (SCRA).

SCRA
Shailaja Lall
Partner
Shardul Amarchand Mangaldas & Co

Edelweiss Financial Services had entered into an SPA dated 8 December 2007 with Percept Group entities. The SPA granted Edelweiss a put option, exercisable upon failure by Percept to comply with certain conditions. When Edelweiss exercised its put option, Percept refused to comply and the parties went into arbitration.

The arbitrator determined that the put option was illegal because, (a) it constituted a forward contract, which is prohibited under section 16 of the SCRA and (b) it was a contract in derivative and since it was not being traded on a recognized stock exchange, was in violation of section 18A of the SCRA.

Verdict

The court held that an option is a privilege to a contract and a contract is formed at a future point in time, to be exercised on the occurrence of a contingency.

SCRA
Shivangi Talwar
Principal associate
Shardul Amarchand Mangaldas & Co

The court explained that in this instance a contract would come into being only on the occurrence of two conditions: (a) failure of a condition subsequent under the SPA; and (b) the exercise by Edelweiss of the option granted to it under the SPA.

The court also held that an option is not a derivative contract. It emphasized the trading aspect of derivatives and held that the law prohibits trading or dealing in options.

The court seems to have adopted the rationale that only when an option or a security is traded on a stock exchange or cleared by a clearing house do they form a derivative and fall under Section 18A of the SCRA. In other words, merely because the contract contains a put option, the contract cannot be termed as a contract in derivative or a contract for sale or purchase of securities. For an option to be a derivative it has to be traded.

Analysis

The court’s rationale that options do not qualify as derivatives, as they are not traded, is in contrast with a large number of judgments that hold that options are per se derivative contracts.

An option essentially derives its value from the underlying shares and would therefore fall within the ambit of the term derivative under section 2(ac) of the SCRA.

The interpretation adopted by the court would lead to a conclusion that an option, by virtue of not being derivative or a contract for sale or purchase of securities, does not have to comply with the conditions stipulated under the SCRA or the Securities and Exchange Board of India Circular dated October 3, 2013 (2013 circular).

Reading the SCRA provisions and the 2013 circular, and in light of numerous judgments on this issue, we are of the view that:

Until October 2013, the position in law was that contracts in derivatives were valid only if they were traded on a stock exchange or settled in the clearing house of a stock exchange.

The 2013 circular validated options of unlisted public companies and clarified that they were not affected by section 18A as it stood at the time, which required derivatives to be traded on a stock exchange or settled in the clearing house of a stock exchange.

All option contracts qualify as derivatives, whether traded on a stock exchange or settled on the clearing house of a stock exchange or not. All option contracts would have to comply with the conditions of the 2013 circular; which are: (a) the securities should have been held for more than a year; (b) the purchase consideration should be in compliance with the Foreign Exchange Management Act, 1999; and (c) the contract should be settled by way of actual delivery of the shares.

The decision of the court has raised some fundamental issues and has not settled the position on option contracts under the SCRA.

It is important that the Supreme Court takes a view, and, if required, necessary amendments be made to the SCRA and the 2013 circular, to finally settle the matter.

Shailaja Lall is a partner and Shivangi Talwar is a principal associate in the general corporate practice of Shardul Amarchand Mangaldas & Co.

SCRA

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